Causes of Insolvency

Household debt in Canada has continued to skyrocket. As of the fourth quarter of 2016, Canadian consumers owed a record $1.67 for every dollar of disposable income they earned. Yet insolvency rates per person have fallen since peaking in 2009, with Ontario consumer insolvency rates expected to fall again in 2016 to levels not seen since 2001.

Matching this overall decline in consumer insolvency rates, Joe Debtor’s debts have also fallen. So why are some people filing insolvency while others with massive debt loads are not?

Joe Debtor: Life on the Margin

Today’s Joe Debtor is not just burdened with debt, he is financially vulnerable. He, or she, is likely part of an identifiable at-risk group: lower income, struggling middle class, student debtors, lone-parents, retired seniors or on disability. These groups represent the “core” insolvent debtor we see today.

Primary Reasons People Give for Filing Bankruptcy

In Canada, in 2016, just over 130,000 individuals filed a consumer proposal or personal bankruptcy¹. In our experience, their financial problems develop for a number of reasons.

Listed Causes of Insolvency Rate
Overextension of credit, financial mismanagement, unexpected expenses 57%
Job related (unemployment, layoff, reduction in pay) 55%
Marital or relationship breakdown 14%
Illness, injury, and health related problems 14%

Financial Mismanagement

Obviously, the generic term “financial mismanagement” is a large contributing factor. In fact, when asked for the cause of their financial difficulties, 57% of our debtors listed “over extension of credit and financial mismanagement” as the leading cause of their financial problems.

Millennials are more likely (63%) to list financial mismanagement as a cause of their insolvency followed by seniors (60%). For millennials student debt becomes a burden they cannot repay if they are unable to find suitable employment in their field.  They are also more likely than any other age group to use payday loans.  In contrast, seniors are dealing with credit card debt accumulated over a lifetime and often have the strongest moral obligation to repay their debts.

Financial mismanagement can include overspending and excessive use of credit, but it often is as simple as not planning for unexpected expenses, such as a car or house repair. When you combine the lack of savings with a major unexpected expense, consumers often turn to credit as a means of making ends meet.

In part, due to the guilt associated with filing bankruptcy, most of the people we see hold themselves wholly responsible for their misfortune and they may not recognize the underlying problems that pushed them into insolvency.

In our experience, a debtor’s financial mismanagement was either caused by, or dramatically increased by, a life altering event. The most common of these include marital separation or divorce, job loss and personal illness.

An increasing factor among those filing insolvency is the increased prevalence of high-risk, high-cost debt. The use of payday loans, quick and easy cash instalment loans and high-risk vehicle financing is on the rise. These debt choices are invariably more expensive than traditional debt, and often even more expensive than credit card debt. Overall, higher borrowing costs, whether due to overall debt levels or choice of debt product, increases a debtor’s insolvency risk.

Separation and Divorce

The general myth is that filing for bankruptcy may cause more family stress and may even lead to divorce. However, we have found the opposite to be true. More than one-quarter (27%) of our clients were separated or divorced at the time of their filing and 14% of our clients cited marital or relationship breakdown as the cause of their financial difficulties.

It is easy to see how the end of a relationship might cause financial problems.  While a couple is together they may have two incomes, but only one set of living expenses (rent, utilities, groceries, etc). They make plans based on the assumption that the relationship will last forever; they incur debt for cars, mortgages on houses and other consumer items.  Once separated, each partner will have their own rent, utilities and other expenses. They will also be limited to their own income. While they are adjusting to their new reality, recently separated people often rely on credit to pay their bills.  This leads to more debt than either party can service, and a proposal or a bankruptcy is often the final result.

Job Loss or Reduced Income

While unemployment has fallen in Ontario since our last report, 55% of our clients indicated that job related issues contributed to their financial difficulties.  This is a significant increase from 37% just two years ago despite Ontario’s strong economic recovery. The major reason is that most insolvent debtors today are in an financially vulnerable risk group who are struggling to make ends meed on a lower than average income. Unstable employment and under-employment are a major concern for millennials and single-parents while older debtors deal with early retirement issues.

Job-related factors can include unemployment and temporary or permanent layoff, but often includes a reduction in income due to a decrease in overtime or a cut-back in total hours worked. It can also include working temporarily in a low-paying job while searching for work that matches their field. If debtors do not have, or have used up their savings and their income is reduced, credit is often used to make up the shortfall.  In fact, less than 1% of insolvent debtors had any cash savings or emergency fund available to help pay bills and keep up with debt payments.

Medical & Health Problems

Despite universal health care in Canada, 14% of our clients cited illness, injury and health related problems as a cause of their financial difficulties.   Pre-retirement debtors (those aged 50-59) reported the highest rate of health related issues at 19% as a they are forced into early-retirement or are on disability due to health reasons.  In fact 10% of pre-retirement debtors were on disability at the time they filed insolvency.

For some, financial trouble starts with time off work recovering from their health problems. During their convalescence they may use credit to survive and pay their day-to-day bills. Once they return to work, they are left with more debt than they can handle. Others may not be able to return to full-time work and find that their disability income is not sufficient to pay their debts as they come due.

In summary, for most people, financial problems are the result of some major life-altering event. Certainly these people must assume responsibility for their insolvency, but in most instances, their financial problems are really a result of not planning for a “rainy day” and not because they set out to deliberately incur more debt.

Tax Debts

Roughly 4 in 10 people we deal with owe money to the Canada Revenue Agency. The above are just the top reasons why they have outstanding tax debts. If you are have more tax debts that you can repay, contact us to discuss your options.The three most common scenarios causing income tax debt.  In no particular order…

#1 – Withdrawing Funds from RRSP

When you take money out of an RRSP, the bank is required to withhold a certain percentage for income tax.  For amounts up to and including $5,000, that amount is 10%.  The tricky part is that the actual amount of tax you should pay is probably much higher.  For many people, their actual tax rate is between 30% and 45%.

Consider a simple scenario.  You take $5,000 out of your RRSP and the bank withholds $500 for income tax.  You do your tax return the next spring and your actual tax rate is 45%, meaning you are required to pay $2,250 of tax on that $5,000 you withdrew.  Since only $500 has been paid, you owe another $1,750.  However, the money is gone because you used it to pay bills.  Suppose you’ve done this for two or three years.  With penalties and interest from the CRA, you could have a tax bill close to $10,000.

What this means is that using RRSP’s to get caught up on debts is potentially very costly.  If you’ve filed for bankruptcy and still have RRSP’s, try to keep in mind the real cost of using those funds.  You can have the bank withhold a higher portion than the minimum required by law.  Here’s some information from the CRA website about minimum withholding rates.

#2 – Part Time and Multiple Jobs

The amount of tax that you are required to pay for any particular year is a complicated formula based on your total income for the year.  The more money you make, the more tax you pay.

Your employer is required to withhold amounts for your estimated taxes.  People can get into trouble when they have more than one job because each employer is estimating without knowing about the other job.  If you have a part-time job, that employer may withhold little or no income tax because they are not required to.

It’s really the same issue as taking money out of your RRSP.  You receive funds without having enough tax taken off.  By the time you figure out how much tax should be paid, the money is gone and all you’re left with is a tax bill and hard feelings.  If you are concerned about this kind of scenario, you can request that one or both employers take off more tax.  It might feel like a difficult decision is money is tight.  With income taxes, it’s pay now or pay later.  It’s easier to a little bit each pay cheque instead of coming up with a large payment at the end of the year.

#3 – Self Employed Not Paying Installments

There are many reasons why it can be great to be your own boss.  However, things haven’t gone as planned if you’ve had to meet with me.  Maybe you’ve lost a major contract.  Maybe you’ve had a significant injury or illness and have no benefits.  Maybe you need some help with bookkeeping.  The volume of government paperwork can be overwhelming.  Once you fall behind, it can feel as though it’s impossible to get caught up.

Legally, you are permitted to operate as a self-employed sole proprietor after you have filed for bankruptcy.  If you are going to do so, finding a bookkeeper to assist you with your paperwork is money well spent.  For others, it is easier to work as an employee.  It’s hard to fall behind on taxes if you are on somebody else’s payroll.